As exciting as the trading landscape is, it can also be challenging to navigate, as the market’s mood swings can generate greed, fear, and hesitation among traders, which can oftentimes cloud their judgment. However, there is a tool that provides insights and enables traders to make smarter decisions: candlestick patterns.
This tool originated in the 18th century in Japan and was built on the idea that trader psychology and the power balance between the bulls and the bears are the most important factors that influence market prices. Munehisa Honma – the creator of the candlestick charts- studied historical price changes and identified patterns that indicated shifts in market control and sentiment, helping him predict price trends and reversals. When used in combination with other technical indicators, these patterns can help traders determine potential market directions. Below, we dive into the types of candlestick patterns that you should know about and offer tips on reading them.
Bullish and bearish candlestick patterns
Bullish candles are an indicator of an upward market movement. They are symbolized by a green or white body, and they happen when the closing price is higher compared to the opening price. Bullish candlestick patterns indicate robust buying pressure and are a sign that there’s a shift toward optimism in the market. The volume and length of these bullish candlestick patterns are paramount: longer bodies with high volume indicate strong bullish sentiment, which can signal the reversal from a bearish to a bullish market or the beginning of an uptrend. Here are the most common bullish patterns to be aware of:
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Hammer. This pattern resembles a hammer pattern and is represented by a short body with a long lower shadow, suggesting buyers have regained control and thus pushing prices up.
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Inverted hammer. In this case, the pattern looks like a hammer but has a long upper shadow and suggests robust buying pressure and a forthcoming bullish market.
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Piercing line. This pattern indicates a significant shift from selling pressure to buying pressure and is a sign of a bullish reversal.
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Bullish engulfing consists of two candlesticks—a small red candle followed by a green one that is larger than the former and engulfs it. This pattern indicates strong buying momentum and a potential market reversal.
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Three with soldiers. This pattern is represented by three long green candles and shows a consistent increase in buying pressure, reflecting a bullish reversal.
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Morning star. This three-candlestick pattern shows that a bearish trend is weakening and that bullish momentum is emerging.
Bearish candlestick patterns are the opposite of bullish candlestick patterns in the sense that they indicate market downturns. They are represented by candles with a black or red body, reflecting a closing price that is lower compared to the opening price. This means that there’s increased selling pressure in the market, which is a sign of fear or pessimism. Recognizing bearish candlestick patterns is important because it enables traders to develop exits or short positions strategically as they prepare for a potential decline in market value.
Some of the most prominent bearish patterns include:
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Hanging man: Hanging man is a pattern with a small body and a long lower shadow that suggests a struggle between buyers and sellers, where sellers gain an edge.
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Bearish engulfing consists of two candles—a small green one followed by a larger red one that engulfs the first—and signals a robust shift from buying pressure to selling pressure.
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Three black crows. It is represented by three long red candles and reflects a strong bearish movement.
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Shooting star. Featuring a small body and a long upper shadow, this pattern reflects a bearish reversal pattern and selling pressure.
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Evening star. This three-candlestick pattern often occurs at the end of an uptrend, showing that there’s a shift to a bearish market.
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Dark cloud cover. With this pattern, a red candle opens higher but closes below the midpoint of the green candle that previously happened, indicating a bearish reversal pattern.
Steps to read a candlestick pattern
If you want to use candlestick patterns to predict market movements, it’s essential to follow a structured approach. The steps below will help you dissect these patterns and decode their meanings so that you can make informed decisions during your trades.
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Identify the components of the candlestick. You cannot read a candlestick pattern if you don’t know what it is made of. Essentially, candlesticks consist of three main parts.: the body, the shadow( also known as wicks), and the color. The body is the candlestick’s thick part and reflects the opening and closing prices for the period, while the wicks are the thin lines below and above the body, indicating the low and high prices for the period. The color of the candlestick shows the direction of price movement in a specific interval.
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Determine the color and meaning of the candlestick. Candlestick colors are incredibly important in technical analysis, as they provide visual cues that allow traders to interpret market sentiment and make informed decisions. Traditionally, bullish candlesticks are represented in white and green, while bearish candlesticks are depicted in black or red.
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Examine the wicks and the body’s length. Suppose the body is long; this is a sign of strong buying or selling pressure. On the contrary, a short body is a sign of less price movement in the market and may indicate indecision between buyers and sellers. When it comes to wicks, long ones reflect a reversal in the market sentiment, particularly if they happen after a considerable price move, while short wicks point out limited price fluctuations.
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Recognize patterns over various candlesticks. This is essential because it can result in more efficient trading decisions. While single candlestick patterns can be useful, they aren’t always reliable on their own. Relying on multi-candlestick patterns can provide more context and reduce false signals, providing a structured approach to trading.
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Contextualize the overall market trend. It’s always paramount to interpret the candlestick patterns within the context of overall market trend. This is because the same pattern can have a totally different implication in a bull market compared to a bear market.
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Combine candlesticks with other technical analysis tools. One of the most common mistakes traders make is to rely on candlesticks alone, but this isn’t an effective way to approach trading. To confirm a trend, it’s always best to combine this tool with other technical analysis indicators, such as moving averages, trend lines, or volume indicators.
Master candlestick patterns to create an edge in trading
Candlesticks are the basis of technical analysis and an invaluable tool that can increase your probability of success. However, they have limitations, and it’s never indicated to rely solely on them to make trading decisions. Remember to use them strategically as part of your trading strategy to gain insights into where the market is going and reduce the risk of having a trade go against you or missing a trade.
